businesses that already have traction, meaning they have customers, validated business models, validated pricing models. That takes time and you have to bootstrap through the various phases to get there.
We want to mitigate your changes of getting rejected by VCs because you went out too soon. In the case of Freshdesk, they did a very nice job of getting customers using a free version of their product and converting a portion of those free users to paying customers, therefore validating both their business model and their pricing model. When you go to investors with a sufficiently large market opportunity, that is a financeable situation.
X: When it comes to nourishing early stage startups, what do you think the Silicon Valley establishment is doing right? What is it doing wrong?
SM: Let’s start with what the valley is doing right. I do a lot of case studies of companies that have made it all the way to $5 million in annual revenue, and in the process I see companies that are fabulous, high-powered companies, not just in Silicon Valley but from other parts of the world. Last week I spoke with a company called Fine Art America. When I did a piece on them for Forbes in 2010 they were at $1 million in revenue, and today they are over $5 million. Guess how many employees they have? Three. To do $5 million in revenue with three people is an immensely complicated task, but the reason this is an important case study is that we have created compelling models for using outsourcing and various other ways of pulling resources together that are highly capital-efficient.
It’s not so much Silicon Valley as it’s the entrepreneurs of the world who are figuring out ways of building companies in very capital-efficient ways. We teach companies how to do this, and it gives them negotiating power. If you are three people and you have revenue of $5 million a year, when you sit down with a VC the negotiating power is in your hands. I’m very much in favor of putting the leverage in the entrepreneurs’ hands, as opposed to the investors’.
Now, there are gaps, and one of them is this: Not everything can be done in a capital-efficient manner. If you are trying to do certain kinds of R&D and technology development, it requires some up-front investment. Silicon Valley is not doing as good a job with these kinds of companies. I was talking to a VC friend the other day and he said he was seeing a lot of interesting things in nanomaterials. I said, “At what point do you invest in a nanomaterial company?” This is very difficult to validate. There has to be some investment in the R&D to get the physics right. He said, “Our assumption is that these technologies are incubated inside university labs and that by the time it hits the investment circuit, all of those risk of R&D are taken out.” Okay, that is a reasonable answer, but it puts all the burden of R&D and core technology development outside the VC industry. And you can talk to healthcare entrepreneurs, biotech and life science entrepreneurs, cleantech entrepreneurs, and a lot of them are really struggling.
This is a real gap. I talked about this in the fourth volume of my Entrepreneur Journeys series, Innovation: Need of the Hour. There is no long-term thinking in Silicon Valley about investing in real innovation. There are some investors who do take such risks, but they are very few and far between.
